The Central Bank of Cuba does not understand the demand for money
The Central Bank of Cuba’s Resolution 111 of 2023, and the explanations given by its brand-new president on the television show “Round Table”, demonstrate the scant understanding that is had of a fundamental concept for monetary policy in any country: the demand for money. This simple formulation serves to show the factors that influence the holding of money by economic agents and illustrates essential relationships that must be considered for the management of monetary policy.
The amount of money demanded by an economy depends on four fundamental variables:
1. The value of transactions: It is associated with the function of money as a means of payment. Money is used to buy and sell the available goods and services at a certain price. The demand for money grows if there is a higher volume of transactions (it can be approximated by real GDP growth) or if the price of goods and services increases due to inflation.
2. The interest rate: It represents the opportunity cost of keeping money in the form of cash. If the interest rate rises, this becomes an incentive to deposit savings in banks and a disincentive to hold cash.
3. Transaction costs and technological developments and payment systems: The evolution of financial technology and payment systems influence the demand for money, since they reduce costs for financial transactions and make it easier to convert savings into cash. For example, magnetic cards, electronic payments, and other digital media tend to reduce the need for physical money.
4. The speed of circulation of money: It refers to the speed at which money rotates from hand to hand in a given period. This variable includes a multiplicity of factors that influence the preference of individuals and companies to maintain more liquidity. It is related to expectations about the future of the economy, informality, uncertainty, etc. It is the most difficult variable to predict and often changes erratically, giving money demand instability.
Putting these four factors in the current Cuban context, we can understand why the demand for money has grown dramatically. The amount of cash in circulation increased at a rate of 10% each year from 2000 to 2017; but from 2020 to 2022 it increased at an annual rate of 86%.
Galloping inflation and the depreciation of the informal exchange rate increase the need for larger volumes of money to pay for goods and services and buy foreign currency. Although real GDP and the number of transactions have fallen, their prices have multiplied several times and more money is required.
Nominal interest rates have remained fixed, making them extremely negative in real terms. That is, people lose money by having it in the bank, since their purchasing power decreases every day due to inflation. Banks have not compensated for these losses by savers by adjusting rates to the new monetary reality that the country is experiencing.
Transaction costs to withdraw cash from banks or through ATMs also promote the demand for money. Long queues, technological delays and intermittent telecommunications are yet another reason to keep money out of banks.
The speed of circulation of money also explains the increase in the demand for cash. Calculated with nominal GDP, the velocity of cash circulation fell by 38% in the last five years compared to the average it presented from 2000 to 2017. The downward trend in the velocity of cash since 2012 is very clear.
This reflects a structural change in the economic system with the evolution of the private sector, but it can also be an indication of increased informality and uncertainty. This change has been translated into a greater demand for cash so that the Cuban peso can fulfill the functions of means of payment and store of value.
A recessive solution
In the explanations in the aforementioned television space, the use of a concept as essential as the demand for money is not distinguished. The financial logic of Resolution 111 is based on the obsolete model of cash inflows and outflows between state banks and households. The graph (without numbers) and the analysis that was used in the “Round Table” to show that money was leaving the banks and not coming back, responds to the way of evaluating monetary policy in the 80s. It is not in tune with the structural transformations that have been taking place in the Cuban economy.
With the diversification of employment, trade, markets and productions and the greater participation of the private sector, the model of cash inflows and outflows of the banks does not say anything useful if the determinants of the demand for money. Cash doesn’t have to go out and back to banks. There is a changing and autonomous demand for money from households and the private sector that cannot be ignored.
If the Central Bank wants to influence the decrease in the demand for money, it would first have to stop runaway inflation. For that, it must stop monetizing excessive fiscal deficits, which requires the implementation of the announced macroeconomic stabilization program. Another determinant of money demand that could be changed is interest rates. An increase in interest rates (at least proportional to the rate of inflation) would increase the opportunity cost of holding cash.
But it is not the case. Preferences continue to be administrative measures, no matter how much they say and write in I don’t know how many documents to the contrary.
The Cuban government has decided to apply forced banking and accelerated digitization of the payment system in just six months. They hope that this will happen in a country with one of the most backward telecommunications infrastructures and with one of the least developed banking systems and payment instruments in the region, and with the oldest society.
Not only do they seem to ignore the fact that advances in banking and digitization require years or decades, but also that trust is a fundamental element in these aspirations. Not long ago (2021) families saw 80% of the value of their bank accounts evaporate as a result of the “monetary order”.
Today almost no central bank pursues specific goals on the amount of money in circulation. This was a widespread practice in previous decades, but it failed due to the instability in the demand for money and how difficult it is to predict what is the “optimal” level of money that an economy requires.
The central banks transitioned to strategies that focus on the inflation rate, interest rates and the diversity of monetary transmission mechanisms. The demand for money has remained as an endogenous variable to the economic and financial situation at all times. Central banks offer the economy all the money it demands. If they don’t, they know that the consequences can be very recessive.
Money is like the oil that drives the engine of the economy. If it is not supplied with the oil it requires, it melts. And the worst thing is that we do not have a yardstick with an exact measure of the amount required by the economy, it changes constantly and due to various factors.
The accelerated banking and digitalization proposed by the Central Bank of Cuba is highly recessive, pretending to know how much money the economy needs or must return to the banks, ignoring the determinants of the demand for money and ignoring the context in which the private sector is operating and the homes.
It shows greater deficiencies in the understanding of the operation of monetary policy adding to the explanations that the forced reduction of cash in circulation will serve to stop inflation and contain the informal economy.
Since the 1990s, the Cuban government has not been able to provide a convertible national currency with a single exchange rate appropriate to the economic and financial reality of the country. The economy has had to malfunction with partial dollarization, dual currencies, multiple exchange rates, overvaluation of the official rate, and exchange controls.
To this cocktail of monetary distortions is now added the first inability, and then the refusal, to offer the cash that the economy demands.
